With the rupee trading just below 60* to a dollar, things are not hunky-dory for Indian markets-both debt and equity
. Foreign institutional investors, or FIIs, withdrew $1.8 billion from equity markets in June, while debt markets saw outflows of $5.4 billion.
The triggers for the FII pullout were clear. Tushar Pradhan, chief investment officer, HSBC Global Asset Management, says the rising dollar pushed up US 10-year Treasury yield from 2.1% to 2.5% within a month, offering better inflation-adjusted returns than most emerging markets. Further, rupee fall
increases prices of imported commodities. Pankaj Pandey, head, Research, ICICI Securities, says 1% rupee fall adds 20-25 basis points, or bps, to wholesale price inflation or WPI.
The fall in inflation made the Reserve Bank of India, or RBI, cut rates by 125 bps since March 2012 to induce growth. As a result, 10-year G-Sec yields moved from 8% in 2012 to 7.3% in May. This cheered fixed income funds as prices of bonds held by them rose. Long-term income funds, or duration funds, returned 11% on an average in the last one year while short-term funds gave 9.5%. However, this rally has been cut short. The sharp rupee fall in the last few weeks
and FII outflows from the debt market have resulted in the 10-year G-Sec yield inching up by 40 bps in the last 30 days to about 7.6 (from a low of 7.2% in June). "Rupee depreciation usually leads to a rise in yields," says Laxmi Iyer, head, Products and Fixed Income, Kotak Mutual Fund.
The rising bond yields hit returns from duration funds as they booked mark-to-market losses on long-duration bonds. Long-term income funds have delivered a negative 0.40% while long-term gilt funds have returned a negative 0.60% in the one month to July 15. Himanshu Pandya, senior vice president and head, Products & Communication, ICICI Prudential AMC, says this is a temporary phenomenon.
The rise in yields, however, has a limited impact upon schemes that invest in short-term papers. That is why returns from liquid and ultra short-term funds have not been affected much.
"There are four components that can be used to understand how fixed income investments will pan out-inflation, economic growth, current account deficit and currency," says Pandya of ICICI Prudential AMC. Three of these were hinting at rate cuts till a few weeks ago. Inflation fell to 4.6% in May, economic growth was a low 5% and the current account deficit, or CAD, fell. Then, the rupee fell and played spoilsport. The fall, say experts, will increase inflation, making it difficult for the central bank to cut rates. In fact, in June, inflation inched up to 4.9% from 4.6% in May.
Pandya of ICICI Prudential MF says a rate cut is unlikely in the near future. In fact, on July 15, the RBI announced a series of measures to tighten liquidity and support the rupee. These measures, have caused some damage- short-term rates have spiked while the long yield curve has firmed up. The one-year corporate deposit, or CD, rate, for instance, rose from 8.30% to 9.85% in a day, while the five-year CD rate rose from 8.75% to 9.6%. The 10-year G-Sec yield rose from 7.6% to 8.1% in a day.INVESTORS' DILEMMA
Pandya of ICICI Prudential says the rate softening is not over but it will be some time before it resurfaces. Hence, it may be worthwhile to revisit your fixed-income strategy. According to Pandya, investors with a six-month horizon should invest in products that have a modified duration of up to six months, for instance, ultra short-term funds. For investments of up to one year, investors could look at products with a modified duration of up to two years (like short-term funds). Those with a horizon of one-two years could look at dynamic bond funds, which are adept at managing interest rate fluctuations. "Investors with an investment horizon of greater than two years can invest in debt/income funds with modified duration of five-six years," he says.
If the yield curve falls by 50 bps over the next few quarters, one can earn double-digit returns from a combination of short- and long-term funds.
Head, Products and Fixed Income, Kotak Mutual Fund
In a scenario where rates are likely to fall over the next four-eight quarters, accrual products are likely to perform better than fixedincome products. These will give you the benefit of accrual income that the fund will earn by virtue of its investments along with capital gains from marking the bonds to the market.
Iyer of Kotak says if the yield curve falls by 50 bps over the next few quarters, one may earn doubledigit returns from a combination of short- and long-term income funds. In fact, prior rate softening cycles of 2000-04, 2008 and April 2012 show that gilt funds performed the best in the debt fund category. These were followed by income funds. This indicates that if the RBI cuts interest rates in the coming year, gilt and income funds are likely to outperform other debt funds. Having said that, investors must not chase returns and should invest according to their risk appetite and investment horizon.
*This copy was written before rupee hit an all time low of 61 per dollar on July 31, 2013.